How to Save for College

With my first grandchild on the way, I want to get started now to help provide for his college education. How should I save in a way that my contributions will have the maximum growth potential? What kinds of plans would provide tax advantages? What should I do so I don’t hurt my grandson’s financial aid eligibility when he is ready for college?

The government encourages saving for a college education by providing tax advantages through college savings plans. The world of these plans is a complicated one, with many, many alternatives available, each with slight variations and differences. To simplify, there are three basic tax advantaged vehicles to help save for college: 529 plans, Coverdall Education Savings Accounts and Roth IRAs. You contribute to each of these in post-tax dollars and each allows your savings to grow free of Federal taxes on the gains. The Coverdall and Roth IRA’s both have both income limits on the contributors and relatively low limits on annual contribution amounts, while the 529 plans generally don’t have those restrictions.

Each of the plans allows the funds to be used for college tuition and fees while some allow the funds to be used for books and room and board expenses as well. In addition, the Coverdall accounts allow you to use the funds to pay for K-12 schooling. (A very useful site for understanding the differences among plans is savingsforcollege.com)

I will focus on 529 plans, because, as noted above, they tend to have the fewest restrictions and so the broadest appeal. The benefits of the Coverdall and Roth plans are very similar to those of the 529, so if you meet the income restrictions and don’t envision making large contributions, you may want to look at them as well.

Each state and the District of Columbia have their own plans. The plans differ in terms of how your contributions are managed, the investment vehicles that they offer, their historic investment performance, the fees that they charge and the expenses that they allow the funds to be used for beyond tuition and fees. In some states the assets are managed directly by a board, in others a third party, such as a brokerage firm. Although, as noted above, the contributions that you make to 529 plans are with after-tax dollars, 34 states and the District of Columbia offer a state income tax deduction as well for contributions to the plan.

Regardless of the state, the 529 plans come in two basic flavors: savings plans and prepaid tuition plans. For the savings plans, you put your funds in, make your investment decisions and watch your funds grow, although they can decline in years of poor market performance, and then withdraw them for qualified educational expenses when your student begins college.

Prepaid tuition plans, offered by twelve states, are like a defined benefit plan except its for college rather than retirement: you pay in a certain amount today or over a period of years and the plan guarantees payment for a certain number of years of college tuition at either a two- or four-year public college or at an independent institution. There is one prepaid plan that is not offered by a state, the Independent 529, is offered by a group of 270 independent colleges and can be used to attend one of those 270 institutions. The prepaid plans lessen investment risk by giving you a tuition guarantee: you have the peace of mind of knowing that regardless of investment performance or increases in tuition, the agreed-upon portion of your student’s tuition will be there when your student is ready. In the environment of the last few years, where tuition increases have been substantial, this guarantee may be appealing. Of course, if the growth in tuition slows, you might, when your student is ready to head off to college, wish that you had invested the funds in a 529 savings plan.

If you withdraw the funds for use for some purpose other than college tuition-related expenses, you will owe taxes on the gain as well as, in most cases, a penalty that will vary depending on the state and individual circumstances.